GAO Report

IRS EXAMINATION SELECTION

Internal Controls for Exempt Organization Selection Should Be Strengthened

Report to Congressional Requesters

July 2015

GAO-15-514

United States Government Accountability Office

This Report is Temporarily Restricted Pending Official Public Release.

United States Government Accountability Office

Highlights of GAO-15-514, a report to Congressional Requesters

July 2015

IRS EXAMINATION SELECTION Internal Controls for Exempt Organization Selection Should Be Strengthened

Why GAO Did This Study IRS examines tax-exempt organizations to enforce their compliance with the tax code. Examinations can result in assessment of taxes or revocation of tax-exempt status, among other things.

GAO was asked to review IRSs criteria and processes for selecting exempt organizations for examination. This report (1) describes these processes and (2) assesses the adequacy of examination selection controls.

GAO reviewed IRS criteria, processes, and controls for selecting organizations for examination and spoke with IRS officials; assessed whether IRS controls followed Standards for Internal Control in the Federal Government; reviewed random probability samples from two populations of examination files; and conducted tests on populations and random probability samples from three databases used in EO examination selection to determine the adequacy of EOs control implementation (for files closed in fiscal year 2014). GAO also conducted eight focus groups on internal controls topics with EO staff who conduct research or make examination selection decisions.

What GAO Recommends GAO is recommending that IRS take 10 actions to improve selection control design and implementation, such as ensuring that all selection procedures are included in the IRM and thus subject to executive management approval, and developing additional examination selection monitoring procedures. IRS generally agreed with the recommendations.

What GAO Found The Exempt Organizations (EO) unit within the Tax Exempt and Government Entities (TE/GE) division at the Internal Revenue Service (IRS) reviews organizations applications for tax-exempt status to determine whether to grant status and oversees existing exempt organizations compliance with the tax code. To identify exempt organizations for possible examination, EO uses a variety of information sources: for example, EO receives referrals of exempt organization noncompliance from third parties, such as the public, and other parts of IRS.

EO uses various controls intended to help it select exempt organizations for examination, in an effort to adhere to TE/GEs mission of applying the tax law with integrity and fairness to all. For example, EO maintains well-documented procedures for several examination selection processes in the Internal Revenue Manual (IRM), IRSs primary, official source of instructions to staff; staff can deviate from procedures that are included in the IRM only with executive management approval. In focus groups, EO staff generally told GAO that these procedures were valuable tools to help them administer the tax law.

However, there are several areas where EOs controls were not well designed or implemented. The control deficiencies GAO found increase the risk that EO could select organizations for examination in an unfair mannerfor example, based on an organizations religious, educational, political, or other views. Examples of internal control deficiencies GAO found include the following:

Staff could deviate from procedures for some selection processes without executive management approval. GAO found that procedures for some processessuch as applying selection criteria to organizations under consideration for review

EO management does not consistently monitor selection decisions. GAO found that IRS does not consistently monitor examinations and database files to ensure that selection decisions are documented and approved, to help ensure fairness. GAOs review of examination files found that approval of some selection decisions was not documented, as required by EO procedures. For example, GAOs analysis of a sample of files suggests that an estimated 12 to 34 percent of cases where staff initially selected an organization for examination, but ultimately decided not to perform the examination, were missing the indication of management approval of the final decision, as required in the IRM. Continuous monitoring is an element of internal control; EO management has not been conducting sufficient monitoring to ensure that required approvals were taking place.

are not included in the IRM, as required by IRS policy. As a result, staff are not required to obtain executive management approval to deviate from these procedures. This increases the risk of unfair selection of organizations returns for examination.

View GAO-15-514. For more information, contact James R. McTigue, Jr. at (202) 512-9110 or [email protected].

Page i GAO-15-514 IRS Examination Selection

Letter 1

Background 5 EO Process for Selecting Exempt Organizations for Examination 7 Design and Implementation of Some Controls Was Adequate;

Other Controls Should Be Strengthened to Reduce the Risk of Unfair Examination Selection 28

Conclusions 51 Recommendations 52 Agency Comments and Our Evaluation 53

Appendix I Objectives, Scope, and Methodology 55

Appendix II Effectiveness of Procedural Control Implementation for Selection Decisions and Approvals 60

Appendix III Comments from the Internal Revenue Service 64

Appendix IV GAO Contact and Staff Acknowledgments 70

Tables

Table 1: Examination Coverage Rate by Type of Tax-exempt Status, Fiscal Year 2014 6

Table 2: Closed Exempt Organization Examinations by Source, Fiscal Year 2014 9

Table 3: Compliance Checks and Compliance Reviews Closed in Fiscal Year 2014 13

Table 4: Reasons for Dismissed Examinations, Fiscal Year 2014 17 Table 5: Outcomes for Referrals Processed in Fiscal Year 2014,

by Referral Type 23 Table 6: Summary of Identified Internal Control Deficiencies by

Examination Selection Process 33 Table 7. Examples of EO Monitoring of Examination Selection

Processes 38

Contents

Page ii GAO-15-514 IRS Examination Selection

Table 8: Number of Months Served by Current Referrals Committee Members, as of April 30, 2015 50

Table 9: Exempt Organizations (EO) Selection Processes, Population, and Sample Descriptions 57

Table 10: Effectiveness of EO Procedural Control Implementation for Selection Decisions and Approvals, Cases Closed Fiscal Year 2014 60

Figures

Figure 1: Exempt Organization Examination Selection (Excluding Referrals) 8

Figure 2: Sources of Exempt Organization Referrals IRS Received in Fiscal Year 2014 18

Figure 3: Exempt Organization Examination Selection Process for Referrals 19

Figure 4: Using Internal Controls in Selecting Exempt Organizations for Examination 28

Abbreviations EO Exempt Organizations EOCA Exempt Organizations Compliance Area IRC Internal Revenue Code IRM Internal Revenue Manual IRS Internal Revenue Service RCCMS Reporting Compliance Case Management System RICS Returns Inventory and Classification System TE/GE Tax Exempt and Government Entities

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GAO-15-514 IRS Examination Selection

441 G St. N.W. Washington, DC 20548

July 13, 2015

The Honorable Charles E. Grassley Chairman Committee on Judiciary United States Senate

The Honorable Peter Roskam Chairman Subcommittee on Oversight Committee on Ways and Means United States House of Representatives

The Honorable Charles W. Boustany House of Representatives

There are 1.6 million tax-exempt organizations in the United States. These organizations have varied purposes and missions, ranging from small social services groups to large nonprofit health systems. Taken as a whole, exempt organizations represent at least 5 percent of gross domestic product.1

An exempt organization must be organized for one of the exempt purposes in the Internal Revenue Code (IRC)such as providing charity, social welfare, programs for veterans, or furthering the interests of the organizations membershipand must operate in accordance with that purpose. Under the IRC, exempt organizations generally are not subject to federal income taxes. For example, contributions received from sources such as individual donations or grants are not taxable. However, exempt organizations are required to pay employment taxes. In addition, they may be required to pay taxes on unrelated business income, such as

1Gross domestic product is the market value of all goods and services produced within a country during a given time period. See McKeever, Brice S and Pettijohn, Sarah L., The Nonprofit Sector in Brief 2014 (Washington D.C.: Urban Institute, October 2014); and Sherlock, Molly F. and Gravelle, Jane G., An Overview of the Nonprofit and Charitable Sector, CRS-R40919 (Washington, D.C.: Congressional Research Service, Nov. 17, 2009).

Letter


from personal property rentals or web site advertising, and most domestic private foundations must pay excise taxes on net investment income.2

The Exempt Organizations (EO) unit within the Tax Exempt and Government Entities (TE/GE) division at the Internal Revenue Service (IRS) oversees exempt organizations compliance with the tax code. EO reviews organizations applications for exempt status and determines whether to grant it. Additionally, EO conducts examinations, which are reviews of the activities and finances of exempt organizations to determine whether they are operating in accordance with their exempt purposes, and have paid taxes they owe.

3

You asked us to review IRSs criteria and processes for selecting exempt organizations for examination. This report (1) describes the processes for selecting exempt organizations for examination, and (2) assesses the adequacy of the controls (including procedures) for selecting examination

If IRS finds noncompliance, it may impose excise taxes for certain types of violations, orif the violations are serious enoughit may revoke an organizations exempt status. In addition, IRS can assess taxes if an organization has not fully paid employment taxes or taxes on unrelated business income, as well as advise organizations on future tax compliance. In fiscal year 2014, IRS closed 8,084 examinations of exempt organizations.

2Unrelated business income is the income from a trade or business regularly conducted by an exempt organization and not substantially related to the performance by the organization of its exempt purpose or function, except that the organization uses the profits derived from this activity. Certain trade or business activities are not treated as an unrelated trade or business. Organizations with $1,000 or more of gross income from unrelated businesses must report it on Form 990-T, Exempt Organization Business Income Tax Return. 3In the past, an inspector general report found that EO used inappropriate criteria to identify exempt organization applications for review. Our report does not cover EOs process for organizations applying for tax exempt status, it only covers examination selection of existing exempt organizations. Treasury Inspector General for Tax Administration, Inappropriate Criteria Were Used to Identify Tax-Exempt Applications for Review, 2013-10-053 (Washington, D.C: May 14, 2013).


cases that EO uses to achieve TE/GEs stated mission of applying the tax law with integrity and fairness to all.4

For the first objective, we reviewed IRS documents that describe the criteria, processes, and controls for selecting exempt organization returns for examination. These documents included relevant sections of the IRC, regulations, the Internal Revenue Manual (IRM), EO procedures and training documents, worksheets to guide examinations and reviews, and summaries of processes prepared by EO officials. We also interviewed IRS officials responsible for overseeing each process. In addition, we obtained data from the following IRS databases: Return Inventory Classification System (RICS), Referrals database, Exempt Organizations Compliance Area (EOCA) database, and EOCA Classification database. The databases contain information on initiated and closed examinations, classification of referrals, and other reviews that can lead to an exempt organizations return(s) being selected for examination.

5

For the second objective, we reviewed EOs examination selection procedures and the related internal controls EO uses to help TE/GE achieve its stated mission of enforcing the tax law with integrity and fairness to all.

Based on our testing of the data and review of documentation and interviews, we determined that these data were reliable for the purposes of this report.

6 We then assessed whether these procedures adhered to Standards for Internal Control in the Federal Government.7

4Internal Revenue Manual (IRM) Part 1, Chapter 1, Section 23.1 (the IRM can be accessed at

We also conducted six focus groups with selected EO staff who are responsible for selecting, or doing research to help select, exempt organization

http://www.irs.gov/irm/). TE/GEs mission, as set forth in the IRM, is to provide its customers top quality service by helping them understand and comply with applicable tax laws and to protect the public interest by applying the tax law with integrity and fairness to all. TE/GEs mission closely aligns with the IRS-wide mission, as set forth in the IRS Strategic Plan for fiscal years 2014 to 2017, of providing Americas taxpayers top-quality service by helping them understand and meet their tax responsibilities and enforce the law with integrity and fairness to all. This report is the first of various reports on IRS examination and collection selection processes that we plan to issue this year. 5Classification is the process of identifying potential noncompliance in a return and making a recommendation on the examination potential for the return. 6IRM Part 1, Chapter 1, Section 23.1. 7GAO, Standards for Internal Control in the Federal Government, GAO-AIMD-00-21.3.1 (Washington, D.C.: November 1999).


returns for examination, and two focus groups of selected EO staff who conduct examinations. We asked questions on internal control related topics, such as the clarity of EO procedures and the adequacy of training to apply these procedures. We used NVivo qualitative data analysis software to conduct a content analysis of themes from the focus groups.

To assess how well EO implemented its procedures and controls and applied examination selection criteria, we used IRM sections, EO procedures documents, and other documents as criteria. We reviewed databases used to document examination selection decisions and random probability samples of database files and examination files. We used the results of those reviews to determine whether selected controls were implemented effectively. We also reviewed a non-generalizable sample of 11 projects that were active during fiscal year 2014.8

We designed uniform data collection instruments for our file and database reviews to consistently capture information on the completeness of required documentation and approvals related to case selection. IRS verified the criteria we used in our instruments. To ensure accuracy, two analysts reviewed each file or database entry we assessed, and reconciled any differences in responses. We then analyzed the results of these data collection efforts to identify main themes and develop summary findings.

We selected those projects to include projects of various sizes (based on numbers of returns examined) and time frames, and we included politically sensitive projects and some projects that relied on data queries of Form 990, Return of Organization Exempt From Income Tax. We reviewed the project files for each project to test whether the documentationsuch as development and approval of examination selection criteriafollowed project development procedures. Finally, we interviewed EO officials about the processes and controls, and to discuss any potential deficiencies we identified.

We conducted this performance audit from May 2014 to July 2015 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our

8EO initiates projects that focus on specific areas of potential noncompliance (such as fundraising) or specific types of organizations (such as community foundations).


findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives. More detailed information on our scope and methodology appears in appendix I.

The tax code provides for 35 different categories of exempt organizations, each covering one or more types of permissible activities. The majority of these organizations are covered by section 501 of the IRC. Section 501 includes private foundations and public charities, as well as other organizations, such as social welfare organizations, business leagues, and veterans organizations.9 However, other types of entities are also wholly or partially tax exempt, such as farmers cooperatives and political organizations,10 as are education-oriented programs such as educational savings accounts and tuition programs.11

Most organizations seeking exemption must submit an application to IRS.

12

9Unless otherwise noted, all section numbers refer to the Internal Revenue Code found at Chapter 26 of the United States Code. Entities colloquially known as 501(c)(3) organizations are defined in the IRC as corporations, and any community chest, fund, or foundations, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals. 26 U.S.C. 501(c)(3). For more information on 501(c)(3) charitable organizations, see GAO, Tax Exempt Organizations: Better Compliance Indicators and Data, and More Collaboration with State Regulators Would Strengthen Oversight of Charitable Organization,

If the information in the application meets the requirements for tax exempt status, IRS will issue a determination letter approving tax exempt

GAO-15-164 (Washington, D.C.: Dec. 17, 2014). 1026 U.S.C. 521 and 527. 1126 U.S.C. 529-530. 12Exceptions to this requirement include churches and organizations (other than private charities) with annual gross receipts that are normally $5,000 or less. 26 U.S.C. 6033(a)(3). Also, section 501(c)(4), 501(c)(5), and 501(c)(6) organizations may self declare themselves to be exempt without filing an application. Although not a requirement, many of these organizations seek IRS exemption as an assurance for potential donors. Depending on the IRC section under which an exempt organization is seeking exemption, the organization will generally submit either Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code; Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code; or Form 1024, Application for Recognition of Exemption Under Section 501(a).

Background


status. Tax exempt organizations are generally not required to file an income tax return. Instead, if an organization normally has $50,000 or more in gross receipts, and meets other requirements, it must annually file one of three versions of the Form 990 information return, which require information on employees, revenue and income, assets and liabilities, program activities, and compensation.13

During examinations, EO reviews a specific returnsuch as a Form 990 or employment tax returnas well as the organizations activities. There can be open examinations on one organization spanning several years, or related returns for a single tax period for that same organization. Some examinations are a result of compliance projects that IRS initiates to identify areas of noncompliance or address known areas of noncompliance. For example, a project on gaming in charity fundraising activities, an activity often conducted by veterans organizations, led to a relatively high examination ratecompared with other rates by tax-exempt statusfor those organizations in fiscal year 2014. Table 1 shows the examination rate by organization exempt status for fiscal year 2014.

Most organizations that fall below the gross receipt threshold of $50,000 and need not file a Form 990 information return are required instead to file an electronic postcard, Form 990-N, which asks for names and contacts associated with the organization, and confirmation of the organizations annual gross receipts.

Table 1: Examination Coverage Rate by Type of Tax-exempt Status, Fiscal Year 2014

Type of tax-exempt status Examination coverage rate Charitable organizations, 501(c)(3) 0.66

Public charities 0.68 Private foundations 0.52

Social welfare organization, 501(c)(4) 0.71 Business league/trade association, 501(c)(6) 0.41 Fraternal societies, 501(c)(8) and 501(c)(10) 0.71

13Form 990, Return of Organization Exempt from Income Tax, Form 990-EZ, Short Form Return of Organization Exempt from Income Tax, or Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Trust Treated as Private Foundation. Churches are not required to submit a Form 990. The term churches includes all similar religious houses of worship entities, such as mosques, temples, and synagogues, among other entities. Church is defined as including any organization claiming to be a church, and any convention or association of churches. 26 U.S.C. 7611(h)(1).


Type of tax-exempt status Examination coverage rate Social clubs, 501(c)(7) 1.64 Labor organization, 501(c)(5), agricultural/ horticulture organization

0.34

Veterans organizations, 501(c)(19) 2.49 Political organizations, 527 0.06 Other 501(c) organizations 1.08 Other (related individual and for-profit entities) a Overall 0.73

Source: IRS Return Inventory Classification System data, end of fiscal year 2014, and TE/GE Research.

Notes: IRS defines the examination coverage rate as the number of examinations closed in the fiscal year for the population (type of organization status), expressed as a percentage of the corresponding number of returns filed in the previous calendar year. a

This examination coverage rate is not included because it is not calculated using a population of exempt organizations in the denominator.

EOs process for selecting returns for examination is complex and includes multiple steps (see figure 1). Referrals, which are complaints against exempt organizations submitted to EO, involve additional steps; they are excluded from figure 1 and discussed later in this report.

EO Process for Selecting Exempt Organizations for Examination


Figure 1: Exempt Organization Examination Selection (Excluding Referrals)

Notes: Some additional paths are possible but not common. For example, some compliance review cases are sent straight to case selection and delivery without being sent first for classification or to triage teams. Also, compliance check cases can be sent for compliance reviews, and vice versa. Selection based on referrals, training, and work for other IRS divisions is not illustrated here. a

Cases that had compliance checks are classified by EOCA. Cases that had compliance reviews are classified by Exempt Organization Examinations. If a case classified by EOCA meets certain criteria, it may be forwarded to Exempt Organization Examinations classification. Cases that had neither compliance reviews nor compliance checks may be classified by either group, depending on the details of the case. The two groups have different criteria and procedures. Cases classified by EOCA as having examination potential are generally sent for correspondence examinations conducted by EOCA. Cases classified by Exempt Organization Examinations as having examination potential are sent to Case Selection and Delivery and are generally conducted as field examinations.


EO uses a variety of sources to identify exempt organizations for possible examination, and conducts review steps that filter out some organizations. Through ongoing programs, time-limited projects, and data queries, EO identifies organizations with characteristics that may pose high noncompliance risks. Referrals point EO toward particular organizations that may be noncompliant. In addition, EO reviews organizations claims for tax refunds and examines those that are questionable; EO selects examination cases for training examiners; and some cases are selected based on programs run by other parts of IRS that relate to exempt organizations. EO also identifies some organizations for examination in the course of conducting other examinations. For a breakdown of closed examinations by source during fiscal year 2014, see table 2. Primary examination sources are listed in the rows, and examinations that are initiated based on other examinations are reflected in the third and fourth columns.

Table 2: Closed Exempt Organization Examinations by Source, Fiscal Year 2014

Primary Source Primary examinations Related pickups Substitutes for return Totals Ongoing programs 1,742 233 307 2,282 Form 990 analytics queries 1,233 254 250 1,737 Referrals 993 279 358 1,630 Compliance projects 724 198 256 1,178 Work for other IRS divisions 238 415 10 663 Claims 480 a 15 5 500 Training 39 20 35 94 Total 5,449 1,414 1,221 8,084

Source: GAO analysis of IRS data from the Return Inventory Classification System, the end of fiscal year 2014. | GAO-15-514

Note: a

Most claims are allowable and are processed and issued in full. Claims that raise questions may result in an examination.

Ongoing programs.14

14IRS does not have a particular term for such work. Program is our terminology.

Every year, EO identifies organizations with characteristics that are known to pose a risk of noncompliance. For example, through a document matching program, EO matches wages reported on Form W-2, Wage and Tax Statement, to those reported on exempt organizations employment tax returns; organizations with

EO Identifies Groups of Organizations with Characteristics That Pose Noncompliance Risks


mismatches have an increased probability of noncompliance.15

Compliance projects are time-limited efforts to study noncompliance risks. Through compliance projects, EO identifies specific areas of potential noncompliance (such as fundraising) or specific types of organizations (such as community foundations), selects and reviews a subset of relevant organizations, and addresses any noncompliance it finds. Compliance projects identify organizations for review using data queries, random samples, and/or nonprobability samples. A committee of TE/GE officials, including EO managers and analysts, has historically been tasked with developing new compliance projects and obtaining approval from EO executives.

Additionally, ongoing programs are used in EOs oversight role. For example, EO performs annual reviews of a random sample of organizations that recently received favorable determination letters to check if the organizations are current with their filing requirements and are operating in accordance with their tax exempt purposes.

Projects that identify areas of significant noncompliancebased on the nature of the issues involved and the number of examinations that result in tax assessments or organization status changesbecome part of EOs ongoing programs. However, in the past few years, EO has decreased its focus on compliance projects and developed a new focus on Form 990 analytics queries (see below).

Form 990 analytics queries identify organizations for review with data queries on Form 990, Return of Organization Exempt from Income Tax. For example, some queries check for missing Form 990 schedules that should be filed, based on boxes checked on Form 990 or Form 990 responses above certain dollar thresholds. To assure alignment with IRS objectives, EO is in the process of aligning Form 990 analytics queries with five focus areas that correspond to agency-wide IRS objectives.16

15The Combined Annual Wage Reporting program is a document matching program that compares federal income tax withheld, Medicare wages, Social Security wages, and Social Security tips reported to IRS on employment tax returns against the amounts reported to the Social Security Administration via the processed totals of Form W-2 and other information returns. When this reconciliation results in an apparent underpayment of employment taxes or overwithholding of income tax, a Combined Annual Wage Reporting case is created.

EO

16EO refers to these focus areas as pillars.


initiated the Form 990 analytics strategy in 2010, and developed and began testing about 150 data queries by 2012. Of the original 150 Form 990 analytics queries, EO had completed testing for 11 and was in the process of testing 20 others, as of April 2015. Successful queries are run on an ongoing basis. As with compliance projects, queries that identify areas of significant noncompliancebased on the nature of the issues involved and the number of examinations that result in tax assessments or organization status changesbecome part of EOs ongoing programs.

Referrals are complaints of exempt organization noncompliance made by third parties, including the public and other parts of EO and IRS. (Although referrals can be made from sources within EO, 90 percent of referrals are from sources external to EO.) Referrals will be discussed in greater detail later in this report.

Examinations conducted in conjunction with other IRS divisions. EO conducts some examinations as part of programs managed by other divisions of IRS. For example, EO conducts some examinations for the Global High Wealth program, managed by IRSs Large Business and International Division, which monitors high wealth individuals and the networks of enterprises and entities they control. Additionally, EO conducts some examinations of exempt organizations for the National Research Program, an IRS-wide effort to develop and monitor measures of taxpayer compliance run by IRSs Office of Research, Analysis, and Statistics. IRS initiated a National Research Program study on employment tax noncompliance in 2010, focusing on Form 941, Employers Quarterly Federal Tax Return, for tax years 2008, 2009, and 2010.

Training examinations, used for training examiners, are identified through database queries selecting for lower-grade cases with compliance issues, and cases with particular topics relevant to training.

Referrals Identify Particular Organizations that May Be Noncompliant

Some Examinations Are Conducted for Other IRS Divisions, and Some Are Used for Training


Claims are exempt organizations requests for tax refunds, adjustments of tax paid, or credits not previously reported or allowed. For example, recognition of tax-exempt status occurs after an organization was formed, effective to the formation date. As a result, an organization can file a claim for refund of income taxes paid for the period for which its exempt status is recognized. Most claims are allowed in full, but claims that raise questions may be considered for examination.

In the course of examining an exempt organizations tax return, EO examiners may become aware of other tax returns that are at risk for noncompliance and should be examined. EO has two sets of procedures in place for opening examinations on those returns when this occurs.

Related pickups. Examiners may expand the examination of a return to include the organizations tax returns for prior or subsequent years. They may also expand the examination to include different forms filed by the organizationfor example, by expanding the examination of a Form 990 to include Form 941, Employers Quarterly Federal Tax Return. Examination staff must obtain manager approval for these examinations.

Substitutes for return. When beginning an examination of a particular tax return, EO examiners check whether the organization is current in its filing requirements for all its returns. If EO examiners find that a return is missing, and are unable to secure the return through contact with the organization, they may prepare a blank, dummy return called a substitute for return (necessary because IRS tracks its examinations based on returns). The organizations related activities, records, and/or documents may then be examined.

Most Claims Are Allowed in Full, but Some Lead to Examinations

EO Identifies Some Organizations to Examine Based on Other Examinations


For some cases, EOs Exempt Organizations Compliance Area (EOCA) may conduct a compliance check or compliance review, processes that can serve as intermediate research steps (see table 3). Some organizations are filtered out through these steps, some are brought into compliance and do not require further work, and some are sent for classification (see below). Other cases are not sent for intermediate research and are sent directly for classification, or directly to Case Selection and Delivery, which manages the pool of returns that may be sent for examination.

Table 3: Compliance Checks and Compliance Reviews Closed in Fiscal Year 2014

Cases closed

Delinquent returns

secured

Organizations referred for

examination

Examinations closed based on

this type of caseCompliance checks

a 3,237 913 102 1,254

Compliance reviewsb

2,005

N/A 152 241

Total Cases 5,242 913 254 1,495

Source: GAO and IRS analyses of IRS data. | GAO-15-514

Notes: aAn organization referred for examination based on a single compliance check or compliance review may be subject to examinations on multiple tax returns. Examinations counted in the final column are based on the types of cases listed, but do not necessarily result from the specific cases counted in the other columns, because compliance checks and compliance reviews closed in a particular fiscal year can result in examinations that close in future fiscal years. b

Excludes mandatory reviews conducted in accordance with Section 9007(c) of the Patient Protection and Affordable Care Act. EOCA conducts mandatory reviews of hospitals that wish to retain or obtain tax exempt status under requirements imposed by the Patient Protection and Affordable Care Act. Pub. L. No. 111-148, 9007, 124 Stat. 119 (2010), 9007(a). Section 9007(a) imposed new requirements that a hospital organization must meet to qualify for tax exemption in tax years beginning after March 23, 2010. 26 U.S.C. 501(r). The Secretary of the Treasury or the Secretarys delegate must review the community benefit activities of each hospital organization to which this section applies, at least once every 3 years. Pub. L. 111-148, 124 Stat. 857, 9007(c). These mandatory reviews are outside the scope of this report. EOCA conducts these reviews as compliance reviews.

Compliance checks involve contact with an exempt organization through a letter or questionnaire. For example, in fiscal year 2014, EOCA sent compliance check letters to organizations that did not file a required Form 990, and to organizations that reported certain types of income on their Form 990 but did not file related required forms. These contacts are a form of education for an organization and can result in the organization coming into compliance with requirementsfor example, by filing a required return. Compliance checks may also be used to determine whether an organization is adhering to record-keeping requirements, and

EO Conducts Research on Some Organizations as Part of the Selection Process


they are used for document matching cases. With some compliance checks, the contact is sufficient to bring an organization into compliance, or to determine that it was already in compliance. Other cases may be sent to EOCAs classification group or a triage team (see below), which determines which cases meet criteria for examination.

Compliance reviews do not involve contacting the reviewed organization. EOCA conducts research using IRS data, external databases, and publicly available information, including information on the Internet.17 Items reviewed may include tax returns, applications for exemption, and websites. For example, compliance reviews are used for the program mentioned above that reviews organizations that were recently granted exempt status, to determine whether they are now operating in accordance with their exempt purposes.18

Some cases identified through a compliance project may be sent straight to Case Selection and Delivery, the pool of returns that may be sent for possible examination (see below). For other cases, an intermediate research step may or may not be conducted (see above), and the next step is classification, a review of the examination potential of a return.

Claims Classification. Classifiers apply their experience and technical expertise to determine whether a claim is allowable by reviewing taxpayer documentation. With management approval, claims classifiers recommend processing refunds, credits, or adjustments for claims which are clearly allowable, as most claims are. Claims that raise questions are sent for possible examination.

17EO uses some proprietary third party databases of information which include public records. 18Compliance reviews are also used to gather information on certain organizations referred to EO as potentially noncompliant by the general public or another source. See below for further discussion on referrals.

EO May Use Claims Classifiers, Other Classifiers, and Triage Teams to Determine Which Returns Have Examination Potential


Other Classification. Classification of most non-claims cases is done by experienced examiners who conduct further research on an organization. They decide which returns to filter out and which to send forward for possible examination, based on their professional judgment of the likelihood of noncompliance and the significance of the identified issues. Returns are classified by one of two groups, EOCA classification and Exempt Organizations Examinations classification, depending on how the case originated and the details of the case. The two groups use different criteria and procedures, but have similar functions and results; classification by either group may result in a correspondence examination, a field examination, or accepting a return as filed and filtering it out from further review.19

Triage Teams. For some EOCA compliance projects, examination selection decisions are made using project-specific criteria applied by project-specific teams, called triage teams, instead of through the usual classification groups. For example, compliance projects that use questionnaires may have triage teams compare questionnaire responses with Form 990 data to select organizations for examination. Triage teams look at the compliance check or compliance review results and apply the project-specific criteria to determine which returns to filter out, and which to send forward for possible examination.

19Cases that had compliance checks are classified by EOCA, and cases that had compliance reviews are classified by Exempt Organizations Examinations. If a case classified by EOCA meets certain criteria, it may be forwarded to Exempt Organization Examinations classification. Cases that had neither compliance reviews nor compliance checks may be classified by either group, depending on the details of the case. Returns classified by EOCA as having examination potential are generally sent for correspondence examinations conducted by EOCA. Returns classified by Exempt Organization Examinations as having examination potential are sent to Case Selection and Delivery and are generally conducted as field examinations.


Case Selection and Delivery. After identification of organizations for possible examination, and after any intermediate research steps and classification, most returns that are selected for possible examination are sent to EOs Case Selection and Delivery unit. (Returns that were classified by EOCA generally skip this step and may be sent straight to examination by EOCA examiners.) At Case Selection and Delivery, the returns become part of a pool of returns that may be sent for examination. Claims that raise questions (see above) are sent for examination. High-priority and certain other referrals (discussed below) are also sent for examination, according to EO officials. Aside from these referrals and claims, decisions are made based on available resources.20 Different examinations must be conducted by different grades of examination staff, depending on the nature of the issues involved and the level of income on the return; large and complex organizations are examined through EOs Team Examination Program.21

Additionally, field examinations generally involve in-person contact and so must be conducted in the geographic area of the exempt organization. Examination offices tell the Case Selection and Delivery unit the grades of examiners available. The unit then sends returns to the offices based on those grades and, in the case of field exams, on the locations of the offices. In fiscal year 2014, 93 percent of returns sent to the Case Selection and Delivery Unit were ultimately sent to examination offices.

20In fiscal year 2014, decisions were based on a priority list in a memorandum from the Director of EO Examinations. Memorandum for All EO Examinations Managers from Director, EO Examinations, Internal Revenue Service, FY 2014 EO Examinations Program Priorities (Oct. 17, 2013), at 2. 21Team Examination Program examinations typically involve significant resources and multiple team members, and may involve coordination with other IRS divisions. There were 269 Team Examination Program examinations initiated in fiscal year 2014. The IRM includes two criteria for including a return in the Team Examination Program: 1) for Form 990 filers, total income or beginning or end of year assets greater than $250 million, and 2) for Form 990-PF and filers of Form 5227(Split-Interest Trust Information Return), income or end-of-year assets greater than $500 million (IRM Part 4, Chapter 75, Section 29.2). In addition to these criteria, project teamssuch as triage teamsmay identify returns to examine, in consultation with Team Examination Program staff. Team Examination Program examinations also occur when EO staff work with IRSs Large Business and International Division on an examination involving an exempt organization.

Returns Selected for Potential Examination May or May not Be Sent to Examiners, Depending on Resources


Dismissals. After selected returns arrive at examination offices, managers and examiners conduct risk assessments on the returns. They may choose not to conduct the examinations, if returns seem to pose limited noncompliance risk or for other reasons. In this report we use the term dismissed to refer to such returns.22 There were 1,858 returns dismissed in fiscal year 2014, for reasons summarized in table 4. The most frequent reason for dismissing a return was that the return was approaching its statute of limitations; IRS must ensure there is adequate time to complete the examination.23

Table 4: Reasons for Dismissed Examinations, Fiscal Year 2014

Other reasons for dismissal included lack of examination potential, and finding no concerns with a claim for a tax refund. A manager may make the decision to dismiss a return if it has not yet been assigned to an examiner. Examiners who identify returns that they believe should be dismissed are required to fill out a form stating the reason and have that form signed by their manager.

Reason

Percentage of examinations dismissed

Expiring statute of limitations 37 Returns with no examination potential for other reasonsa 32 Claims allowed in full 23 No large, unusual, or questionable items 5 Lack of resources 3

Source: RICS data. | GAO-15-514

NOTES: a

Examples of other reasons are the examination being unlikely to result in a material change, the examination of a prior year return resulting in no change, and the organization having already taken steps to correct a reported issue.

22IRS uses the term survey for examinations that are not initiated or not pursued after pre-examination reviews reveal a reason not to conduct the examination; the term is used IRS-wide. See IRM Part 4, Chapter 75, Section 16.3.2. 23The Internal Revenue Code has limitations on assessment and collection which require that the IRS assess, refund, credit, and collect taxes within specific time limits. See e.g., 26 U.S.C. 6501, 7611(c)(1). Such a limit is called the statute of limitations. When it expires, IRS can no longer assess additional tax, allow a claim for refund by the taxpayer, or take collection action.

Examiners and Managers Make the Final Decision on Whether to Conduct an Examination


EO has special procedures for processing referralscomplaints of potential noncompliance of exempt organizationsand selecting organizations for possible examination based on referrals. Referrals are the third largest source of EO examinations. EO receives referrals from many sources. They may originate externallymost commonly from the general publicor from other IRS divisions that identify potential noncompliance. Figure 2 summarizes the sources of referrals received in fiscal year 2014; data from recent years showed similar breakdowns.

Figure 2: Sources of Exempt Organization Referrals IRS Received in Fiscal Year 2014

Note: Data from fiscal years 2012 and 2013 showed similar results, although for both years, referrals from other TE/GE and EO employees were lower, and there were more referrals from other sources. Also, there were slightly fewer (about 74 percent of referrals) referrals from the general public in 2012. Other includes referrals from news sources, congressional members or staff, and other federal agencies and sources that could be internal or external to TE/GE.

Processing referrals involves several steps, depending on the allegation in the referral or the type of organization involved. Figure 3 summarizes the steps for different referral types.

EO Processes Thousands of Referrals on Potential Noncompliance Each Year


Figure 3: Exempt Organization Examination Selection Process for Referrals

Notes: Some referrals are filtered out through each of these steps, excepting compliance reviews. a

Certain referrals that raise limited concerns are worked as compliance checks rather than examinations.

Referral classification. EO currently has five classifiers, part of Exempt Organization Examinations, who sort incoming referrals into basic categories, based on an initial review of the referral. All referrals are to be logged into the Referral Database. Referrals are sorted to identify those that do not involve exempt organizations and therefore should go to other IRS divisions (misroutes), referrals that do not mention an organization or a violation of the tax code (no issue referrals), and referrals that should


be classified for possible examination. After sorting, EO sends an acknowledgment letter to the individual who submitted the referral (except IRS employees).

Each of these classifiers specializes in one or more types of referrals, such as political activity referrals, and reviews those referrals for examination potential, according to the EO referrals manager. The majority of referrals are considered general referrals, meaning that a single classifier makes a decision about examination potential. For these referrals, there are no specific criteria for identifying examination potential. Instead, referrals are classified using the facts and circumstances of each referral, which involves a classifier using his or her experience, and all available data on the referral, to determine whether potential noncompliance exists. Some referrals, such as those originating with whistleblowers24 or those pertaining to the Tax Equity and Fiscal Responsibility Act,25

Referral committees. Referrals that deal with political activity allegations or what IRS has identified as sensitive allegations or organizations are also reviewed by a three person committee.

have additional steps or criteria for classification. The classifier is responsible for documenting his or her decision in the Referral Database, as well as providing an explanation for the decision. According to the EO referrals manager, this includes mentioning any research conducted to corroborate the allegation and, for referrals classified as no issue, an explanation of the decision not to pursue.

26

24Whistleblowers are individuals who spot problems in their workplace, while conducting day-to-day personal business, or anywhere else.

The committees are composed of a rotating set of senior examination staff or managers who make the final decision about examination potential. According to the Internal Revenue Manual (IRM), committee members should rotate every 12 months on a staggered schedule to maintain continuity and expertise;

25The Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. 97-248, 96 Stat. 324, (Sept. 3, 1982) established a complex set of examination, processing, and judicial procedures that affect the way IRS works with the partnerships and limited liability companies that file as partnerships and not with the separate partner level examinations. These referrals are reviewed to determine if any tax exempt partners need to be examined to reflect any adjustment made by the partnership. 26EO does not have a complete definition of sensitive referrals, although IRM Part 4, Chapter 75, Section 5 provides the example of the information submitted by an elected official (other than Congress or Executive Branch).


volunteers are to be solicited in a memorandum from the Director of Examination for EO.27

1. Political Activities Referral Committee. Reviews allegations of potentially noncompliant exempt organization political activities, including churches.

EO has three types of committees to review referrals.

28

2. Church Committee. Reviews referrals concerning churches for allegations other than political activity.

The Political Activities Referral Committee reviewed 501 referrals in fiscal year 2014.

29 EO currently has two Church Committees, which handle the same types of cases. Church and High Profile Committees (see below) combined reviewed 43 referrals in fiscal year 2014.30

3. High Profile Committee. Reviews referrals concerning exempt organizations that have attracted media attention, that have financial transactions with known or suspected terrorist organizations, or are referrals from elected officials.

27IRM Part 4, Chapter 75, Section 5.6. 28If workload is heavy, the committee that reviews political activities identified through Form 990 queries will review political activity referrals, according to an EO official. 29The term Churches includes all similar religious houses of worship entities, such as mosques, temples, and synagogues, among other entities. Church is defined as including any organization claiming to be a church, and any convention or association of churches. 26 U.S.C. 7611(h)(1). 30The Referral Database does not have an identifier to differentiate between Church and High Profile Committee Referrals.


A committee may also review referrals involving other factors, identified by a classifier, which indicate that committee review is desirable for reasons of fairness and integrity, according to the Referrals Procedures document.31

Each committee member is responsible for reviewing the referral and providing a determination on examination potential, along with comments, into the Referral Database. Political activity referrals, and other referrals as requested, are sent for a compliance review to provide additional information to committee members to inform their decisions. Referral committee members are to use the reasonable belief standard as criteria for examination selection. The outcome for the referral is determined by a majority, i.e., at least two of the three committee members being in agreement. This outcome is automatically tallied in the database when members enter a decision. Committee decisions are considered final and cannot be overturned, although, as discussed below, church examinations must go through additional steps before initiation.

Referrals prioritization. For each referral selected for potential examination in fiscal year 2014, a priority level was assigned that guides how quickly the referral is sent to the field for examination. For political activity referrals, the Political Activities Referral Committee determines whether a political activity referral is high priority or other, based on criteria in the Referrals Procedures document. 32 All other referrals are assigned one of seven priority levels. For fiscal year 2014, priority levels were intended to feed into 16 workload priorities, as laid out in a memorandum from the Director of EO Examinations.33

31IRS, Tax Exempt and Government Entities Division, Exempt Organizations Referral Procedures (revised September 2014).

These priorities guided examination management in deciding which cases to work. EO management has discontinued the prioritization memoranda, according to EO officials. Instead, starting with fiscal year 2015, referrals requiring

32These criteria are the amount of money expended, size of audience for the alleged activity, significance of the political campaign, frequency of the alleged activity, degree of specificity to identify a candidate or the support/opposition, degree of candidate participation in the activity, and the degree to which the organization is soliciting contributions to support its political campaign activity. 33Memorandum for All EO Examinations Managers from Director, EO Examinations, Internal Revenue Service, FY 2014 EO Examinations Program Priorities (Oct. 17, 2013), at 2.


collaboration with another IRS business division and those dealing with fraud are considered high priority, and therefore will be examined before other referrals. The Case Selection and Delivery unit assigns other referrals to the field based on grade level and location of examination staff, as described earlier in this report. Referrals that are assigned for examination may be dismissed if examination management or staff do not find examination potential, if the return is approaching the statute of limitations, or for other reasons.

Referral outcomes. Most referrals are not selected for potential examination; referrals that are selected may not actually become examinations due to resource constraints, or other considerations, according to EO officials. Table 5 summarizes referrals processing during fiscal year 2014.

Table 5: Outcomes for Referrals Processed in Fiscal Year 2014, by Referral Type

a

Duplicates In processb cSelected for

potential examination

Not selected for examination Total d

General 912 1,900 946 3,453 7,211 Political Activities Referral Committee

188 281 169 356 994

Church or High Profile Committees

338 86 27 444 895

Misroutes and uncategorized

4 5 2 923 934

Total 1,442 2,272 1,144 5,176 10,034

Source: GAO analysis of IRS Exempt Organizations Referral Database, as of Sept. 26, 2014.| GAO-15-514 aThe table shows all referrals that had processing activity during fiscal year 2014; some referrals were received in previous years. bDuplicates are either a referral on the same organization and issue sent in by multiple people, or the same referral sent in by the same person. cAs of the end of the fiscal year, these referrals had not yet completed the classification process. d

Referrals not selected for examination include no issue referrals, referrals to be reviewed for possible future examination, and those that were transferred to compliance reviews, compliance checks, or other groups.


Statutory requirements must be met before EO can initiate an examination on a church.34 Specifically, after determining that there is reasonable belief (based on facts and circumstances recorded in writing) that a church may not qualify for exemption, IRS must first issue a Notice of Inquiry to the church.35 An inquiry serves as a basis for determining whether the organization qualifies for exemption as a church, whether it is engaged in activities subject to tax, or whether an excess benefit transaction has occurred.36 If there is a reasonable belief that an inquiry is necessarybased on facts and circumstances of the case, including committee review if a referral is involvedthen the information is sent to a designated official, who must be an appropriate high-level Treasury official.37 Currently, the designated official is the Director, Exempt Organizations, who must also get concurrence from the TE/GE Commissioner, according to EO officials. Under the statute, an appropriate high-level Treasury official must reasonably believe that an inquiry is necessary.38

According to the IRM, division counsel and an EO area manager must review the notice before it can be issued.

39 If a church does not respond to the inquiry or cannot resolve IRSs concerns, EO examination staff will prepare a Notice of Examination and a memorandum on why an examination is necessary, according to the IRM.40

3426 U.S.C. 7611.

Two levels of division counsel and the designated official must approve the notice. These statutory procedures are followed for employment tax issues, but do not

3526 U.S.C. 7611(a)(1)-(3). 36An excess benefit transaction is one in which an economic benefit is provided by an applicable tax-exempt organization, directly or indirectly, to or for the use of a disqualified person, and the value of the economic benefit provided by the organization exceeds the value of the consideration received by the organization. A disqualified person is someone in a position to exercise substantial influence over the affairs of the applicable tax-exempt organization. 37An appropriate high-level Treasury official is defined as the Secretary of the Treasury or any delegate of the Secretary whose rank is no lower than that of a principal Internal Revenue officer for an internal revenue region. 26 U.S.C. 7611(h)(7). 3826 U.S.C. 7611(a)(2). 39IRM Part 4, Chapter 76, Section 7.5.2. 40IRM Part 4, Chapter 76, Section 7.5.

Churches Undergo Additional Reviews before Examinations Are Initiated


apply to routine requests, such as solicitation of a delinquent employment tax return or information requested to resolve inconsistencies revealed in the matching program, among other things.41

EO initiated one examination on a church in fiscal year 2014, and two in fiscal year 2013.

42 EO officials told us they suspended new church examinations from 2009 to January 201343 after a 2009 district court case,44 which ruled that, at the time, the designated official was not the appropriate high-level Treasury official envisioned by Congress.45 In 2009, IRS issued a Notice of Proposed Rulemaking putting forward the Director of EO as the designated (i.e. appropriate high-level Treasury) official; to date, final regulations have not been issued.46

4126 C.F.R. 301.7611-1.

EO officials said they resumed church examinations, based on existing regulations, and modified the process by adding another level of review, as the designated

42We identified at least 72 referrals on potential political activity in churches in the Referral Database that were selected for examination by classifiers in fiscal year 2014 and 40 in fiscal 2013. Although selected by classifiers, these referrals would not necessarily become examinations, as they would need to follow the notice of inquiry procedures under IRC 7611. Also, between June 2013 and April 2014, EO suspended examinations on new political activity issues, while procedures related to political activity examinations were being reviewed and updated, according to EO officials. That hiatus likely also affected the number of church exams. 43Examinations on church noncompliance related to political activity issues, such as campaigning for a candidate, did not resume until April 2014, according to IRS officials, when EO resumed examinations that were previously started and suspended on political activity allegations. 44United States v. Living Word Christian Center, 103 AFTR 2d 714, Civil No. 08-mc-37 ADM/JJK, D.Minn. (Jan. 30, 2009). 45IRS established that an appropriate high-level Treasury official was a Regional Commissioner (or higher Treasury official). 26 C.F.R. 301.7611-1, Q&A (1). However, the Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. No. 105-206, 1001(a), 112 Stat. 685 (1998), eliminated the position of Regional Commissioner. IRS officials stated that starting in 2013, the review process changed and the Director of Exempt Organizations solicited the review and concurrence of the TE/GE Commissioner. 46Amendments to the Regulations Regarding Questions and Answers Relating to Church Tax Inquiries and Examinations, 74 Fed. Reg. 39,003 (Aug. 5, 2009).


official is the Director of EO, who acts in concurrence with the TE/GE Commissioner.47

The Financial Investigations Unit examines exempt organizations that are selected as a result of projects or queries, or have been identified with potential indicators of fraud. There were 121 Financial Investigations Unit examinations of exempt organizations initiated in fiscal year 2014. Classifiers and examination staff may refer returns to the Financial Investigations Unit if they believe indicators of fraud or other criteria are met, as listed in the IRM.

48

The Criminal Investigation division investigates potential criminal fraud.

Examination staff who suspect fraud fill out a form describing the issues and consult with an exempt organizations fraud specialist. A Fraud Technical Advisor must approve placing the return in fraud development status. If the Financial Investigations Unit finds indicators of fraud, the case will be referred to IRSs Criminal Investigation division. The Financial Investigations Unit has also provided classifiers with supplemental criteria to help identify potential fraud. Classifiers may also refer a return to the Financial Investigations Unit.

49

Referrals from EO Examination. Examination staff may recommend a case if they identify general fraud indicators and the case meets criminal criteria. They will suspend the examination, and Criminal Investigation will review the case. EO Examination makes referrals via a form, which explains the basis for the suspected fraud. Criminal Investigation staff will develop the case, identify any possible charges, and make a recommendation to the

There were 96 criminal investigations initiated on exempt organizations in fiscal year 2014. Criminal investigations of exempt organizations can originate in one of two ways, according to a senior IRS analyst working in Criminal Investigations.

47In April 2015, a Freedom of Information Act lawsuit was filed in the U.S. District Court for the District of Columbia, against the IRS by an entity called Alliance Defending Freedom, for the failure to release documents related to church inquiries and examinations since January 2009, and documents related to 26 C.F.R. 301.7611-1. Alliance Defending Freedom v. IRS (No. 1:15-cv-00525). 48IRM Part 25, Chapter 1, Section 2 and IRM Part 4, Chapter 75, Section 21.8. 49The Criminal Investigation division is not part of TE/GE, but they do investigate cases involving exempt organizations.

Organizations with Complex Financial Transactions May Be Reviewed for Potential Fraud


U.S. Attorney for prosecution, which may lead to an indictment and eventual trial.

Referrals from U.S. Attorneys, local law enforcement, and other informants. Criminal Investigation staff conduct preliminary reviews of the referral, and then develop cases in the same manner as those originating from EO Examination.

The criteria for moving forward with a prosecution resulting from a referral are based on the judicial district of the taxpayer. Each U.S. Attorney has different types of cases or minimum tax revenue loss they are willing to prosecute; there is no checklist of criteria, according to a senior IRS analyst working in Criminal Investigations. For example, one region may prosecute a tax revenue loss of $250,000, while another region may prosecute a loss of $100,000.


We found that the design of certain examination selection controls aligned with the IRM or with standards for effective internal control (see sidebar and figure 4). We also found that the implementation of some of these controls (i.e. the steps used for examination selection) aligned with these standards. As such, these controls may serve as tools to help EO meet TE/GEs mission of applying the tax law with integrity and fairness. However, we found that other controls were deficient in either their design or their implementation. These control deficiencies increase the risk that EO could fall short of TE/GEs mission and select organizations for examination in an unfair mannerfor example, based on an organizations religious, educational, political, or other views. Effective internal control helps agencies adapt to shifting environments, evolving demands, and new priorities. As programs change and agencies strive to improve operational processes and implement new technology, management should continually evaluate its internal control system so that it is effective and updated when necessary.

Figure 4: Using Internal Controls in Selecting Exempt Organizations for Examination

Design and Implementation of Some Controls Was Adequate; Other Controls Should Be Strengthened to Reduce the Risk of Unfair Examination Selection


We found several examples of examination selection processes that met design and implementation internal control standards.

Design of Internal Controls. Agency management designs control activities in response to its objectives and risks to achieve an effective internal control system. Control activities are the policies, procedures, techniques, and mechanisms that enforce management directives to achieve an agencys objectives and address related risks. Internal control standards require control activities to be effective and efficient in accomplishing an agencys control objective. As part of their control activities, agencies must ensure that internal controls are clearly documented. IRS requires primary sources of guidance with an IRS-wide or division-wide impactsuch as policy documents, procedures, and guidelinesto be included in the IRM.50

This requirement is intended to ensure that IRS employees have the approved policy and guidance they need to carry out their responsibilities in administering the tax laws.

50IRM Part 1, Chapter 11, Section 2.2

Multiple Examination Selection Processes Met Both Design and Implementation Control Standards


In alignment with IRM requirements, EO maintains well-documented procedures for several examination selection processes. For example, EO management has developed IRM sections for referrals classification, claims processing, Financial Investigations Unit case processing, and examinations. During our focus groups, employees working closely with these IRM procedures generally reported they were useful.51

In focus groups, we found that staff who use these (and other IRM sections) to conduct their work generally view them as valuable tools that help them administer the tax law (see text box).

For examinations, there were IRM sections on several different types of examinations and steps in the process, including substitutes for return, related pickups, the Team Examination Program (used for large and complex organizations), and church examinations.

Selected EO employee focus group participants statements regarding IRM procedures:

I came off the streets and can read the IRM and understand it. Kudos to the IRM to the degree that this is my springboard to know what to do and how to do it.

The IRM is excellent, it tells you everything.

I go straight to the IRM. It's there to provide fair and consistent treatment.

To further align with IRM requirements, EO is working to draft and implement IRM procedures for testing and adopting 990 analytics queries.52

51We consider examinations to be case selection processes because examinations may be dismissed and examinations may be expanded to include related pickups and substitutes for returns.

For example, EO will likely formalize its current practice of requiring approval to test queries not already listed in EOs annual

52EO officials provided us complete drafts of two IRM sections in April 2015. One IRM section, the Small Business/Self-Employed divisions IRM for Compliance Initiative Projects (IRM Part 4, Chapter 17, Sections 1.1 - 4.11), is being revised to incorporate EO language and contains procedures for developing, approving, and managing Compliance Initiative Projects, which will include EO projects and queries. The second IRM section (IRM Part 4 Chapter 75 Section 8) is a new EO-specific section on projects and queries that outlines specific roles and responsibilities of certain EO staff during this process.


workplan, according to one of the draft IRM sections. This new draft IRM also describes certain development work to be conducted prior to implementing a query. EO plans for both IRMs to be implemented in the last quarter of this fiscal year, according to EO officials. Having written procedures will help ensure that EO is taking action to address internal control risks. EOs publishing these procedures in the IRM increases transparency to the public.

Implementation of Internal Controls. Internal control standards require that control design be adhered to in practice, known as control implementation. EOs control design for examination selection includes requirements for various types of documentation of examination decisions and approvals. We found that multiple EO processes successfully implemented several types of such controls. For example, both EOCA procedures and referrals procedures require Case Chronology Recordsrecords that track actions taken on a caseand we found that in practice, 100 percent of cases closed in fiscal year 2014 contained Case Chronology Records.53

See appendix II for more examples of successful implementation of controls for recording decisions and approvals.

53Our tests for Case Chronology Records for both EOCA and referrals were population-level tests of cases closed fiscal year 2014. For EOCA, each of 5,242 cases had Case Chronology Records. For referrals, each of 5,317 cases had Case Chronology Records.


Internal control standards require that management and employees establish and maintain an organization-wide environment that sets a positive and supportive attitude toward internal control and conscientious management. An agencys management plays a key role in providing leadership in this area, especially in setting guidance for proper behavior. The IRM sets standards of conduct for treating taxpayers fairly, stating that it is the duty of agency officials to determine the correct amount of tax owed with strict impartiality as between the government and taxpayer, and without favoritism or discrimination between taxpayers.54 It also says that agency representatives must adhere to the law and recognized standards of legal construction in making conclusions of fact or application of the law.55

Selected EO employee focus group participants statements regarding the meaning of fairness:

We found in focus groups that EO employees who conduct examinations and other reviews consistently equated fairness with assessing organizations strictly by whether they comply with tax law and with treating similar types of taxpayers equally. EO employees relatively uniform understanding of fairness and the alignment of their understanding with the IRM is a significant step toward EO achieving a positive control environment, the foundation for all other control standards.

(You should) treat everyone alike, it doesnt matter who filed the information, its what they filed. (You look to see) are they doing the right activity (as permitted by their tax exempt status), organizing properly, and capturing transactions accurately. It doesnt matter the perspective of an organization. And you should support everything you do by regulations and code.

You should treat each organization in a specific regulation section in the same manner. If its a 501(c)(4), if one organization is allowed to do something, then they all arethey are treated fairly and equally.

54IRM Part 1, Chapter 2, Section 13.1.5. 55IRM Part 1, Chapter 2, Section 13.1.5.

EO Has Established Key Factor for Building a Positive Control Environment


We found that while EO had established various procedures over its examination selection processes, there were several areas where EOs controls were not well designed or implemented (see table 6). Taken as a whole, these control deficiencies increase the risk that EO could select organizations for examination in an unfair mannerfor example, based on an organizations religious, educational, political, or other views.

Table 6: Summary of Identified Internal Control Deficiencies by Examination Selection Process

Identified deficiency Affected process(es) Control Design Procedures not documented in IRM Compliance checks

Compliance reviews EOCA classification

Some outdated or inaccurate aspects of procedures Referrals Dismissed examinations Team Examination Program

Insufficient monitoring requirements for case approvals and explanations

a EOCA classification Dismissed examinations Examinations (Claims) Referrals

Inadequate IRS process for tracking and maintaining closed case files

b Examinations

Some inadequate documentation of project selection criteria and controls for certain project activities

c Form 990 data analytics Ongoing programs Projects

Control Implementation Lack of data dictionaries for databases Compliance checks Compliance reviews EOCA classification Examinations Referrals

Lack of Privacy Impact Assessments for databases Compliance checks Compliance reviews EOCA classification Referrals

Only one classifier is reviewing each type of referral Referrals Referral committee members are not rotating Referrals

Source: GAO analysis. | GAO-15-514

NOTES: aThe Team Examination Program conducts examinations on large and complex organizations. bThe results of our review were statistically indeterminate, but of potential concern. c

Claims and related pickup files.

Other Controls Needed Improvement or Standards Were Not Followed


Internal control standards require that controls, and an agencys documentation of them, should be properly managed and maintained. As noted previously, IRS requires primary sources of guidance with an IRS-wide or organizational impactsuch as policy documents, procedures, and guidelinesto be included in the IRM.56 This requirement is intended to ensure that IRS employees have the approved policy and guidance they need to carry out their responsibilities in administering the tax laws. Moreover, including primary guidance in the IRM fulfills certain legal requirements. For example, one way IRS complies with the Freedom of Information Act is by making most IRM guidance available online to the public.57

EOs primary sources of guidance for compliance checks, compliance reviews, and EOCA classification are not included in the IRM, as required by the IRM. In 2008, EO officials drafted high-level descriptions of compliance checks and compliance reviews for the IRM, but these were never published. According to EO officials, staffing levels were insufficient to complete this work. Instead, EO has developed procedure documents for compliance checks, compliance reviews, and EOCA classification

56IRM Part 1, Chapter 11, Section 2.2. 575 U.S.C. 552(a)(2)(c).

Deficiencies in Control Design

Compliance Check, Compliance Review, and EOCA Classification Procedures Are Not Documented in the IRM as Required


outside of the IRM. These documents provide instructions to staff about the required approvals, documentation, and other steps taken as part of each case selection process. The compliance check and compliance review processes also have job aid documents with information relevant to processing cases.

By not complying with agency requirements and standards for internal control, the internal procedures for compliance checks, compliance reviews, and EOCA classification are not covered by the same standards as the IRM. For example, deviations from the IRM are only allowed with approval by executive management and with appropriate communication to employees, whereas these standards do not explicitly apply to other documents. Reliance on procedures that are outside of the IRM creates the risk that EO staff could deviate from procedures without executive management approval, which could result in unfair selection of organizations returns for examination. Excluding these procedures from the IRM also reduces transparency, since they would be available to the public if they were in the IRM.

Internal control standards require that controls should be documented and properly managed and maintained. According to the IRM, IRS program managers are responsible for ensuring that IRM content is reviewed annually for accuracy and completeness and for analyzing issues that may necessitate changes.58 Likewise, supplemental guidancesuch as job aids and desk guidesmust be reviewed at least annually to ensure the content remains accurate.59

A provision in the IRM for manually selecting returns for the Team Examination Program, rather than using standardized criteria based on an organizations income and assets, is not actually used, according to EO officials.

We found that EO examination selection procedures, including the IRM, contained outdated and, in some cases, inaccurate material, such as the following examples:

60

58IRM Part 1, Chapter 11, Section 1.6.5.

Further, the IRM requires that a worksheet be completed for returns under consideration for the program. The worksheet includes a section on factors considered in the examination

59IRM Part 1, Chapter 11, Section 2.2.1. 60IRM Part 4, Chapter 75, Section 29.2. The IRM refers to the standardized criteria for the Team Examination Program as bright line standards.

Some Aspects of Procedures for Examination Selection Are Outdated or Inaccurate


selection decision and a section for reviews and signatures. EO officials stated that the worksheet has not been used since 2012 and they are currently updating that section of the IRM.

A section on closing dismissed examinations requires that a stamp with management signatures be placed on original, non-electronic, returns that are dismissed.61

However, this requirement is not implemented consistentlyin our file review, we found very few of the paper files had this stampand given the increasing reliance on electronic copies of returns, this requirement may be becoming less relevant. Further, EO has another control in place (discussed in appendix II) which suffices to document management approval for dismissed returns. EO management said they will use the signatures on paper returns until all forms can be electronically signed.

A section on requirements for opening an examination of a related return states that staff should document the managers approval to expand the examination, and a written statement of approval should be included in the examination file.62 EO officials told us that managers approve related pick-ups within the Reporting Compliance Case Management System (RCCMS), the database EO uses for tracking examinations, which has replaced the need for written documentation of approval within the file.63

We also found examples of outdated and inaccurate guidance in procedures documents. Specifically, in the September 2014 Referrals Procedures document we found the following:

The procedures include criteria for sending a referral to a High Priority Committee. However, there is no High Priority Committee, according to EO officials. The EO officials described this as a typo and said that all mentions of the High Priority Committee should be replaced with High Profile Committee. This mistake was also in the previous years version of the document.

61IRM Part 4, Chapter 75, Sections 16.3.2.1 and 16.3.2.2. 62IRM Part 4, Chapter 75, Section 12.9. 63RCCMS is an information system that supports examination selection and processing by providing case management, inventory control and routing capabilities. Managers receive a notice within RCCMS, though an email-like prompt, that examination staff have requested approval for a related-pickup.


The procedures include a requirement that subject matter experts periodically review referrals screened out by the classifier responsible for political activity referrals to confirm that exclusion from committee review is appropriate. EO officials stated that this requirement was originally formulated in 2012, but the reviews have not been conducted because of a subsequent decision to send all political activity referrals for committee review.

We provided EO with these, and other, citations of outdated or inaccurate procedures. The EO Director acknowledged that there are outdated procedures and IRM sections for EO processes, and that many of these are the result of changes that have occurred over the past 18 months. EO officials said they were in the midst of an effort to update outdated and inaccurate guidance in the IRM and anticipated completing this process by the end of August 2015. Outdated and inaccurate procedures pose the risk that employees might follow incorrect procedures and therefore inconsistently administer tax laws.

According to internal control standards, controls should generally be designed to assure that ongoing monitoring occurs in the course of normal operations. Monitoring involves management assessments of the design and operating effectiveness of in

Documents

GAO Report